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Migrating to the “base rate” regime from BPLR – the impact on you and what you should do

Banks have moved to the “base rate” system from the “benchmark prime lending rate (BPLR)” system. What does it mean? How does it affect you? Read on.

Starting 1st July 2010, banks have moved to a system of “base rate” from the existing system of “benchmark prime lending rate (PLR)” that was introduced in 2003.

The background – Basics of a bank’s business

The main activity of banks is to gather funds from the people like you and me in the form of deposits, and lend this money to industries and individuals.

The bank gets the money at a certain rate of interest (say, the interest rate on fixed deposits – FD), and lends it at a slightly higher rate. The difference between these rates is what the bank earns for itself as profit.

Why do we need a base / benchmark rate as a reference?

Each bank would have a different cost for the funds – in simple words, each bank would pay different rate of interest to its depositors. For example, State Bank of India (SBI) might pay 6% interest on a 1 year FD, whereas a cooperative bank might pay 9% for the same tenure!

Therefore, the rate at which the banks lend the money would also be different for different banks. But how would the public know what the normal lending rate of the bank is?

This is the reason why a reference rate is required. It is a rate that is derived based on the actual cost of funds to the bank. This is the rate based on which all loans of a bank are supposed to be priced.

The PLR was introduces in 2003 to ensure that banks publish their lending rates based on their true cost of funds. All lending was expected to be at or above the BPLR. This was a fair expectation, as you can’t expect a bank to lend below its cost of funds!

However, over time, competition forced banks to do exactly the opposite.

Banks stopped adjusting the BPLR when the interest rates went down – therefore, the BPLR lost its relevance as a rate reflecting the cost of funds for banks.

And when the RBI allowed lending at below BPLR rates, the banks started giving out most of their loans below the PLR / BPLR (also known as sub-PLR or sub-BPLR loans). In fact, the loans were priced as “BPLR minus 200 basis points”! (That is, 2% less than the BPLR)

For example, banks made home loans at 8% when the BPLR was 12%!

Thus, the PLR / BPLR system became totally meaningless.

The new “Base Rate” system

Due to these limitations, a new “base rate” system is being implemented from 1st July 2010.

This new framework would have two major benefits:

Banks would be required to revise the base rate every quarter

Banks would not be allowed to lend below the base rate

This would bring the much needed transparency to the loan market in India.

What happens to the existing loans?

The Reserve bank of India (RBI) has given out guidelines which say that customers of existing loans (based on BPLR) should be given an option to switch to the new base rate system without any fee.

Even for banks, maintaining two systems of PLR and base rate would be administratively difficult – so you can expect the banks to encourage you to shift to the base rate system.

But the golden question is – will the rate of interest on your loan change if you switch?

No, it won’t – only the method of calculating the rate would change. And you would get a benefit immediately if the base rate if revised downwards (remember – base rate needs to be revised every quarter).

Example

Let’s say you have taken a floating rate home loan which is at BPLR minus 200 basis points. (2% less than the BPLR). Right now, the BPLR is 12%, so your loan is at 10%.

As you would have observed, if the interest rates go down, the bank does not necessarily reduce the BPLR. So, even if the overall interest rates go down by 0.5%, your loan would remain at 10%. Yes, it is unfair, but thats the reality today!

When you change to the base rate system, the current rate for your loan would remain the same. So, if the bank’s base rate is say 7.5%, your loan would be marked as “base rate plus 250 basis points” (or, 2.5% above the base rate). So, there would be no immediate change for you.

However – and this is important – what would change is how a change in interest rate is passed on to you. Since banks have to revise the base rate every quarter, any change in interest rate – either downwards or upwards – would be passed on to you in a maximum of 3 months.

This is a big leap forward, considering the fact that till now, most floating rate loan customers have only seen an upward movement in their interest rates.

Should you switch to the base rate system?

Just to reiterate – a switch from a BPLR based loan to a base-rate based loan is free – there would not be any charge.

Shifting to the base rate system makes the most sense for people who have taken a floating rate home loan in the last 5-6 years. This is because the equated monthly installment (EMI) in the initial years goes mostly towards paying the interest – therefore, any reduction in interest rate would have the maximum impact on such loans.

But in any case, shifting to the base rate system would not have any adverse effect on any floating rate loan. So, by default, you should shift to the new system.

And while shifting, you should also renegotiate the terms of your loan (mainly the interest rate) if the interest rate on your loan is higher than the market rate. Yes, this won’t be free – most banks charge 1.5% to 2% of the outstanding loan amount as a fee while renegotiating the terms.

However, this makes sense if the interest rate you are paying is higher than the prevailing rate, AND if there are many years left to your loan – the benefits of a lower rate would outweigh the one time charge in this case.

People who have loans where the interest rate is fixed for the entire tenure of the loan (pure fixed-rate loans) of course need not shift to the base rate.

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I am a financial planner catering to Indians worldwide. I am passionate about personal finance and financial planning, and believe in long term investment for achieving your financial goals. No wonder stocks are my favourite!

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